chapter 29 - retirement planning

7/29/2019 Chapter 29 - Retirement Planning

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Retirement Planning Chapter 29Tools & Techniques of

Financial Planning

Copyright 2007, The National Underwriter Company 1

What is Retirement Planning?

Retirement Planning is the process of insuringthat there are sufficient financial resources to

provide a desired lifestyle in the retirementyears. It consists of several tasks:

Determining retirement financial needs.

Analyzing current resources to provide forretirement needs.

Working with retirement plan distributions and seeing that yourclient follows certain rules in a timely manner.

For more detailed information on retirement planning, seethe Tools & Techniques of Employee Benefit and RetirementPlanning.


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Determining Financial Needs for Retirement

Identifying client lifestyle expectations andquantifying income needs in retirement.

Determining what resources are currentlyavailable to pay for retirement and whether theywill be sufficient for the clients desired lifestyle.

Analyzing future income flow and sources offunds to meet future needs.


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Determining Financial Needs for Retirement

The process also includes obtaining informationon qualified plan benefits, and recognition of theappropriate role of insurance in retirementplanning.

These steps, combined with TVM analysis, will

determine what additional funds need to besaved and invested to meet client needs.


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The Current Environment

Some of the factors you and your clients need tounderstand to successfully plan for wealth accumulationand retirement include the following:

The magnitude of the financial requirements facing retireesduring retirement.

The impact of inflation on retirement.

The effect that financial well-being has on the quality of life. The planning alternatives that are available for the purpose of

developing a plan that leads to financial self-sufficiency.


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The Current Environment for Retirees

75% of elderly families cannot afford luxury items.

Pension plans at best replace only about one-half of apersons salary.

An employer-sponsored retirement plan and SocialSecurity together almost certainly will not provide

adequate funds for maintaining the pre-retirementstandard of living during retirement.


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The Current Environment for Retirees

Many people will have to deal with deteriorating healthduring retirement.

Poor health creates the problem of increased medical bills.

Increases purchases of services that retirees were once ableto perform for themselves (for example, home maintenance).

Even at what may appear to be low levels, ongoinginflation during the retirement years will erode thepurchasing power of the retirees income.


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Determining Financial Needs

Tripod of Economic Security.

Employer-Sponsored Plans. Crisis in Social Security.

Combination Concerns.

Inflation.

Estimating the Inflation Rate.

Personalizing the Inflation-Rate Assumption.


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Factors Affecting Retirement Planning

Retirement can be as long as one-third of a personslifespan.

Most income is produced in the middle third of ones life,so building up enough money to sustain a lifestyle for anequal time is a massive task.

Most people dont really have any idea what they want todo in retirement, making it difficult to quantify needs.

Even at low levels, inflation can cause what appeared tobe enough money to lose its purchasing power, causingretirement to be a time of anxiety and worry rather than asatisfying time of life.


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Tripod of Economic Security

Traditionally, economic security in retire-ment was supported by three legs:

Social Security.

Employer pension plans.

Personal savings and investment.

Recently, the long-term viability of the Social Securitysystem has come into question, and employer pensionsare becoming more rare, leaving the persons savingsthe one leg left.


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Employer-Sponsored Plans

Not designed to replace all pre-retirement income. Bestonly replace about one-half.

Integration with Social Security reduces that to 20-25%. Based on entire career, not the final working years. Do not provide protection against pre-retirement inflation.

Profit-sharing plans do not assure that a contribution will bemade each year.

Defined benefit pension plans are being replaced by 401(k)plans that put savings and investment burden on theemployee.

Many employers are terminating all pension and profitsharing plans.


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Guaranteed Income for Life

Most defined contribution plans do not guarantee anincome for life.

The responsibility for managing resources becomesthe employees.

There are no cost-of-living increases the employee

gets a lump-sum and must do the best he or she can.

Many people are ill-equipped to manage a portfolioby inclination or education.


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Crisis in Social Security

Social Security is meant to be a safety net.

However, it does not come anywhere near replacingpre-retirement income.

Many observers question whether Social Security willbe able to meet the demands for benefits after the

year 2020.


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Percentage of Pre-retirement Income Providedby Social Security


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Biggest threat to economicindependence in retirement isinflation.

As prices go up year by year, the

retiree has to draw down moremoney to have the same amount ofpurchasing power.

Even if Social Security keeps pace

with inflation, at 4% inflation, in about10 years, the combination of pensionand Social Security will have onlyabout 75% of the purchasing powerthat it had in the first year.


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Inflation Causes Growing Deficit


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Estimating the Inflation Rate

No one can accurately project future inflation rates.

Over the period from December 1950 to December

1992 inclusive, the average compound increase inprices was 4.2%.

Since 1992, however, it has been under 3%compounded.

Many people may be comfortable with projecting a3%-4% annual increase for long-term estimates ofinflation. Others who are more cautious andconservative in their approach may want to choose ahigher long-term inflation assumption.


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Personalizing the Inflation-Rate Assumption

Retirees typically consume more services than the nationalaverage, and services generally have a higher inflation rate

than goods. There may be regional differences and personal habits that

make your clients inflation rate different than the nationalaverage.

CPI places great emphasis on housing prices, which may not

change for retirees who have completely paid for homes. Biggest error as a planner is to underestimate inflation, since

that will leave the client with a severe shortfall. Focus on long-term rates for your estimates, and do not let

one or two years distract you from that reality.


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Estimating the Length of the Retirement IncomeNeed Expected Starting Date for Retirement. Longevity.

Individual Life Expectancies. Special Consideration for Married Couples. Second-to-Die Probabilities. First-to-Die Probabilities.

Planning for Two Separate Income Streams. Caution is Advised. The Length of Retirement. Estimating Retirement Income Needs.


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Expected Starting Date for Retirement

Because it was the age to collect full Social Securitybenefits, age 65 was the age most people used in

planning. However, 67 may be more realistic now sincethat is the Normal Retirement Age under SocialSecurity for individuals born in 1960 and later years.

However, average age of retirement for Americanworkers is 62. Some of this may have been caused byforced early retirement and some by the fact that onecan draw reduced Social Security benefits at that age.

Long-term commitments such as mortgages or collegeexpenses may force a later retirement age.


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Longevity

Predicting how long a person will live is not easy. If ones relatives have lived well into their 80s, then

genetically there could be an expectation that one will alsohave a long life-span.

Others, whose relatives died young, may not expect to livethat long.

One of the biggest fears of retired persons is outliving their

money. Even knowing the average life expectancy, since the proba-

bility of a person living beyond the average life expectancyfor someone their age is greater than 50%, it is clearlyimprudent to base predictions on average life expectancy.


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Individual Life Expectancies

Consider John and Judy, age 65 and age 62. The median age of death, where a person has exactly a 50/50

chance of surviving that long or longer, for them as singlepersons is 15.7 and 22 years, respectively. However, half the people will survive beyond their median

ages of death, so it would be unwise to use the median agesof death.

According to the survival probabilities, John has a 25%chance of surviving almost 22 years to age 86.9 and a 10%chance of surviving almost 27 years to age 91.8. Judy has a25% chance of surviving almost 28 years to age 90.9 and a10% chance of surviving about 34 years to age 96.2.

How much risk can you take that you will run out of income?


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Single Life Expectancy


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Special Consideration for Married Couples

For couples, simply using the longest life expectancy willunderestimate the length of time expected until the

second spouse dies.

For a couple both aged 65, the difference is about 4years.

Therefore, using second-to-dietables in estimating retirement needwill be more accurate for couples.


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Second-to-Die Probabilities & First-to-DieProbabilities It is rarely a good idea to assume less than 30 years in

retirement for a couple. However, the chance of BOTH

living that long is usually fairly small.

For second to die, the probability is that one of the twowill live longer than either of their life expectancies. Forfirst to die, the probability is that one of the two will diesooner than either of their life expectancies.


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Second-to-Die Probabilities & First-to-DieProbabilities (contd) Thus, the period of time for which one needs to plan

to have sufficient retirement income for two people

together is less than the period of time one wouldneed to plan to have that same total income for twopeople considered separately.

However, the period of time beyond the first death forwhich one needs to plan to have the lesser requiredsurvivor income is longer than the greater of the twopeoples life expectancies.


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Planning for Two Separate Income Streams

Typically, one person can live on about two-thirds theincome needed for two people.

When planning for a couples retirement funding, you canbreak the planning into two separate income periods orincome streams.

The first income stream is the amount necessary to meetthe survivor-income requirement with the period of need

based upon second-death probabilities. The second income stream is the additional income (in

addition to the survivor-income provided in the first incomestream) required to meet the joint-income need with theperiod of need based upon first-death probabilities.


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Caution is Advised

Longevity trends have averaged 2% - 6% increase every10 years for the past five decades.

This means that using todays tables for computingretirement needs for people decades away fromretirement age could severely understate the need.

In addition, financial planning clients tend to be bettereducated, be in better health and be more affluent thanaverage, all factors leading to greater longevity.

Never forget that average life expectancy tables meanthat there is at least a 50-50 chance that the person willlive longer than the average age.


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The Length of Retirement

Overestimating the length of retirement is lessserious than underestimating it.

No one is going to complain about being better off inretirement than expected, but the fear of running outof money is constant and can be debilitating for theretiree.

The monitoring of the financial plan over the yearswill keep the retirement plan on track.


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Estimating Retirement Income Needs

Set up a budget as if the person were retiring today.Compute the lump sum needed at retirement, using

conservative estimates of longevity, inflation andinvestment return.

Project the future value of retirement assets the clientalready has to retirement age.

If present assets are sufficient, fine, but if not, computea savings and investment schedule to meet the need.

As always, monitor progress toward goals.


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Obtaining Information on Qualified Plan Benefits

Annual Benefit of Statements.

Defined Contribution Type Plans. Defined Benefit Plans.

Vesting.

Summary Plan Descriptions. Tax Forms.

Plan Administrator.


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Annual Benefit Statements

An employee in an ERISA plan must be provided withannual benefit statements, a summary plan description,

appropriate tax forms and access to a plan administrator.

The benefit statement must show the accrued benefitsand vesting status.

It may show projected Social Security benefits, familydeath benefits, and value of any contributions theemployee has made to the plan.


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Defined Contribution Type Plans

Benefit consists of accumulated account balance.

Balance includes contributions by the employer,contributions by the employee and investmentearnings, plus in some cases, forfeitures by non-vested employees who have left the plan.

Value may go down if investment return is negative.


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Types of Defined Contribution Plans

Profit-sharing plans.

IRC Section 401(k) plans (also

called cash or deferred plans). Money-purchase plans.

Employer stock-ownershipplans (generally referred to asESOPs).

IRC Section 403(b) plans (alsocalled tax-sheltered annuityplans or tax-deferred annuityplans).

Simplified employee pensionplans (also called SEPs).

Salary-reduction simplifiedemployee pension plans(also called SARSEPs).

Stock bonus plans.

Thrift plans.

Savings plans. Target benefit plans.

Cash balance plans.

SIMPLE IRAs.

SIMPLE 401(k) plans.


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Defined Benefit Plan

A defined benefit plan defines the benefit theemployee will receive at retirement, usually based on

earnings and years of service. The benefit may be based on the final salary and the

number of years worked for the employer. In theseplans, the accrued benefit is the current value of thefunds the employee has earned to date that will be

used to buy the pension benefit. When reading the annual benefit statement:

Note whether the benefit is the current or projected benefit. Are benefits stated in current or future dollars?


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Vesting

To receive a benefit, the plan participant may have tobe in the plan for a specified number of years.

This waiting period is called the vesting period andbenefits that the employee will receive even if heleaves the company are vested.

There are two kinds of vesting schedules:

Cliff vesting: The employee is not vested at all until a certaindate, then is 100% vested.

Graded vesting: A certain percentage of the employeesaccrued benefit is vested per year over a period of years.Five year vesting is very common.


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Summary Plan Descriptions

The summary plan description gives more detail andmay include explanations of:

Early retirement provisions.

Normal retirement age.

Deferred retirement provisions.

Payout options available at retirement.

Potential pitfalls. Claims procedures.

In addition, the Summary Plan Description will usuallyexplain how benefits are computed.


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Tax Forms & Administrator

Tax Forms In addition to the annual benefit statement and summary plan

description, employees will also be supplied with a variety ofretirement-related federal tax forms. Chief among these is Form1099R. This form is sent whenever a person receives a lump-sum distribution from the retirement plan or whenever a personis receiving annuity payments or periodic payments.

Plan Administrator In addition to all the written information employees receive

about their plans, they also have access to a plan administrator,benefits adviser, or human-resources representative. In somecases, the same person may wear all three hats; in others, ateam of experts is available to advise employees.


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Role of Insurance in Retirement Planning

Insurance in General.

Assessing Risks. Life Insurance.

Disability Income.

Medical Insurance.


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Insurance in General

Any wealth accumulation plan assumes a continuationof the ability to earn money and that assets, once

acquired, will stay intact. One of the major tasks of retirement planning is to

assure that risks in the clients life do not derail theirretirement plans.

Loss of earning power through death or disability orloss of assets through property damage ormalfeasance can destroy the best-laid plans.

Insurance is the method of handling risk most oftenused for retirement planning.


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Assessing Risks

Some risks will be retained because the premium costto use insurance is great compared to the risk involved.

Insurance is the best value when the risk is unlikely(meaning a low premium) but the risk could bedevastating to the insured.

For example, it is highly unlikely that the average home-

owner is going to face a negligence suit for millions ofdollars. However, if he or she did, it would be crushing.So an umbrella policy for $2 million, which is typicallyonly about $250 per year, would be a great buy.


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Life Insurance

Life insurance protects a family against the loss ofincome or increased expenses due to the death of

the insured.

The amount of life insurance needed is the remainingamount in the projected wealth accumulation plan.


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Disability Income

A client has a greater chance of suffering a disabilitythan of dying, yet the impact on the wealth

accumulation plan might even be worse with themedical expenses needed to treat the disability.

Disability income insurance can replace the incomefrom a job or keep a business afloat during thedisability of the client.

Since an elimination period of 90 days or more willcost much less than a shorter period, the financialplanner must assure that the client keeps anemergency fund of 3 to 6 months living expenses.


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Medical Insurance

Medical costs have spiraled up muchfaster than have other costs in the economy.

An unexpected illness or accident could costhundreds of thousands of dollars in medical bills.

Although most medical insurance is obtained throughthe employer, self-employed clients will need assistancein obtaining medical insurance at a reasonable price.

The most reasonably priced medical insurance is

the HMO, however, there are a number of other variations ofmedical insurance. Employees rarely have much choice: Self-employed can make the decision of what kind of insurance theywant. Choosing a high-deductible plan can provide insuranceagainst devastating loss with a lower premium cost.


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Retirement Plan Distribution Planning

What options does the plan provide? Defined Benefit Plan Distribution Provisions.

Tax Implications. Nontaxable and Taxable Amounts. Taxation of Annuity Payment. Lump Sum Distributions. Taxation of Death Benefits.

Federal Estate Tax on Distributions. Lump Sum vs. Deferred Payments: The Tradeoff. Penalty Taxes. Penalty for Distributions too soon. Penalty for Distributions too late or not enough.


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What Options does the Plan Provide?

Found in Summary Plan Description.

Some plans may have several choices ondistributions, while others may only allow a lumpsum.


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Defined Benefit Plan Distribution Provisions

Must provide a joint and survivor annuity.

For single participant, benefit is usually a life annuity. Any option that the plan offers that eliminates the

participants spouse must be agreed to in writing bythe spouse.

Other common options are a period certain annuity ora lump sum distribution.


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Defined Contribution Plan Distribution Provisions

Sometimes will provide annuity benefits, but mostoften offer lump sum.

Sometimes the employee can just take withdrawalsas needed.

If an annuity option is desired, but not offered by theplan, the employee can always roll the lump sum

distribution over to an IRA at a life insurancecompany and take it in the form of an annuity.

Lump sums can also be rolled over into IRAs atinvestment firms, mutual fund companies or banks.


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Tax Implications

Some participants just want the highest income possible inretirement, and do not want to think about taxes.

The planner must consider:1. the direct income tax on the lump sum or periodic distribution.

2. penalty taxes.

3. estate taxes.

4. generation skipping transfer taxes.

A qualified plan distribution may be subject to federal, state,and local taxes, in whole or in part.

This section will focus only on the federal tax treatment.Federal tax is usually higher than state or local and manystates exempt retirement distributions.


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Nontaxable and Taxable Amounts

While the bulk of most retirement plan distributionswill be taxed as ordinary income, some will include a

tax-free return of the employees own money. If an annuity is taken, payments will be proportionally

taxable and tax-free according to the ratio of theemployees cost basis in the plan.

An exception for after-tax contributions made prior to1987 for certain plans is that those will be treated asnon-taxable until the entire pre-1987 contribution hasbeen recovered.


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Determining Tax on a Distribution

The first step is to determine the participants cost basis inthe plan benefit. The participants cost basis can include:

1. The total after-tax contributions made by the employee to acontributory plan.

2. The total cost of life insurance reported as taxable income bythe participant if the plan distribution is received under the samecontract that provided the life insurance protection.

3. Any employer contributions previously taxed to the employee

for example, where a nonqualified plan later becomes qualified.4. Certain employer contributions attributable to foreign services

performed before 1963.

5. Amounts paid by the employee in repayment of loans that weretreated as distributions.


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Taxation of Annuity Payments

The annuity rules of IRC Section 72 apply to periodicplan distributions made over more than one taxable

year of the employee in a systematic liquidation ofthe participants benefit.

Amounts distributed are taxable in the year received,except for a proportionate recovery of the cost basis.

The method used for recovery of the cost basisdepends on the participants annuity starting date.


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If the annuity starting date is after December 31, 1997 and theannuity is payable over two or more lives, the excludable portion of

each monthly payment is determined by dividing the employeescost basis by the number of payments shown in the table below:

If the combined ages Number of

Of the annuitants are: Payments

Not more than 110 410

More than 110 but not more than 120 360More than 120 but not more than 130 310

More than 130 but not more than 140 260

More than 140 210

R i Pl i


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If (a) the annuity starting date was after November 18, 1996 andbefore January 1, 1998 and the annuity is payable over two or morelives, or (b) the annuity starting date is after November 18, 1996

and the annuity is payable over one life, the excludable portion ofeach monthly payment is determined by dividing the employeescost basis by the number of payments shown in the table below:

Number of

Age Payments

Not more than 55 360More than 55 but not more than 60 310



More than 70 160

R ti t Pl i


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Lump Sum Distributions

A lump sum distribution may be desirable for retirementplanning purposes, but the distribution may be large enough

to push most of it into the highest tax bracket. In determining the tax on a lump sum distribution, the first

step is to calculate the taxable amount of the distribution.

The taxable amount consists of (a) the total value of thedistribution less (b) after-tax contributions and other items

constituting the employees cost basis. If employer securities are included in the distribution, the net

unrealized appreciation of the stock is generally subtractedfrom the value of a lump sum distribution.

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Taxation of Death Benefits

In general, the income tax treatment that applies to deathbenefits paid to beneficiaries is very similar to that of lifetime

benefits payable to participants; however, more favorabletreatment applies to spouse beneficiaries than to otherbeneficiaries.

Either the annuity rules or the lump sum special tax provisionsmay be available to the beneficiary receiving a death benefit.

However, an additional income tax benefit is available, in thatif the death benefit is payable under a life insurance contractheld by the qualified plan, the pure insurance amount of thedeath benefit (Total life insurance benefit Cash Value) isexcludable from income taxation.

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Federal Estate Tax on Distributions

Generally, the value of a death benefit payable froma retirement plan is includable in the estate of

participant.

There have been attempts to manipulate incidents ofownership in such a way as to keep from playingestate tax by using life insurance.

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Lump Sum vs. Deferred Payments : The Tradeoff

Advantages of a lump sum distribution include The ability to roll over certain distributions.

10-year averaging tax treatment (limited to certain distributionsto individuals who reached age 50 before 1986). freedom to invest plan proceeds at the participants not the

plan administrators discretion.

The contrasting advantages of a deferred payout are:

deferral of taxes until money is actually distributed (however,such deferral can also be obtained in the case of a rollover). continued sheltering of income on the plan account from taxes

while money remains in the plan.

security of retirement income.

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Penalty Taxes for Taking Distributions TooSoonEarly distributions from qualified plans, 403(b) tax-deferredannuity plans, IRAs and SEPs are subject to a penalty of

10% of the taxable amount of the distribution, except fordistributions:

Made on or after age 59. Made to the plan participants beneficiary or estate on or after

the participants death.

Attributable to the participants disability. That are part of a series of substantially equal periodic

payments made at least annually over the life or life expectancyof the participant, or of the participant and beneficiary (separa-tion from the employers service is required, except for IRAs).

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Made following separation from service after attainment of age55 (not applicable to IRAs).

That are certain tax credit ESOP dividend payments, or To the extent of medical expenses deductible for the year

under Code Section 213, whether or not actually deducted.

In addition, certain distributions made from IRAs for thepayment of health insurance premiums by unemployed

individuals, and certain distributions used for higher educationexpenses or first-time home purchases may be exempt fromthe penalty.

Penalty Taxes for Taking Distributions TooSoon (contd)

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Penalty for Distributions Too Late or NotEnough

Distributions from qualified plans, 403(b) tax-deferredannuity plans, IRAs, SEPs, and 457 governmental

deferred compensation plans must begin by April 1 ofthe calendar year after the participant attains age 70.

There is an annual minimum distribution required; ifdistribution is less than the minimum, the penalty is

50% of the amount that should have been distributedbut was not.

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Penalty for Distributions Too Late or NotEnough (contd)

The minimum distribution is determined by dividing theparticipants account balance (generally as of

December 31 of the preceding year) by theparticipants life expectancy, determined under aUniform Lifetime Table. set forth in regulations.

Following the death of the participant, the remaining

benefit may generally be distributed over the lifeexpectancy of the beneficiary, determined undertables set forth in the regulations.

chapter 29 - retirement planning

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